Financial Accounting Standards Board

The FASB recently issued an exposure draft on new accounting standards concerning litigation contingencies.

The gist of it is that companies who are the defendants in lawsuits will be required to disclose the contentions of the parties and tell the end-users of the financial statements how they can obtain further information on point.

The proposals would require disclosure of publicly available quantitative information, such as the claim amounts, other relevant non-privileged data, and in some cases filers would disclose how much they would be entitled to draw from insurance and other sources against a judgment.

This is hardly the board's first look at the issue. The FASB put out a draft in June 2008 (which only SEEMS like twenty years ago!). This draft attempts to address some of the criticisms that were levelled at that one.

Nonetheless, I'm sure this will be a bone of contention in the accounting/auditing world for a long time yet.

Three brief items

1. Auction for Genzyme?

Genzyme Corp., a biopharm company based in Cambridge, Mass., has rejected a takeover offer from Sanofi-Aventis, the largest drug manufacturer in France.

According to a Bloomberg story, the discussions thus far have been informal, but "Sanofi may send a formal letter to Genzyme detailing its interest in an acquisition as soon as this week."

Genzyme has had the pleasure of Carl Icahn's company for some time now. Icahn curently controls two seats on the board. Icahn will surely make his views on the subject known if this does play itself out over the weeks to come.

GlaxoSmithKline is also sometimes mentioned as an interested party, so a real auction for Genzyme is a possibility.

2. Higher cross-border bid.

Alimentation Couche-Tard, the Canadian convenience store concern that owns the Circle K brand, has increased its bid for Casey's General Stores. It was bidding $36 a share in April and has now raised that to $36.75.

This values Casey's at $1.9 million, including debt says DealBook.

The offer expires at 5 PM on August 6 -- which, it so happens, is my baby sister's birthday. (Hello, Beth!)

Oh, and perhaps I' naive, but this strikes me as odd.

3. GSI Group Emerges from Chapter 11.

GSI is a multi-national family of companies that supply parts ("precision technology") to the medical, electronics, and industrial markets. Parts that, so far as I can tell, involve lasers.

Three of the entities within this family filed for chapter 11 reorganization in November 2009, in Delaware: GSI Group Inc., the parent Canadian holding company; GSI Group Corp., of Massachusetts; and MES International, Inc., a non-operating subsidiary of GSI Group Corp.

But now they have returned from that legal world of the undead to that of the truly living.

The Boston Business Journal, in May, described the descent into bankruptcy as
"a slew of regulatory and accounting setbacks that stemmed from revenue-booking practices between 2004 and 2008."

That got me curious, so I went here. Seventeen months ago, and eight months before its bankruptcy filing, GSI announced the results of an internal accounting probe and admitted to material revenue-recognition errors.

Bristol-Myers Squibb

The board of directors of Bristol-Myers Squibb, (NYSE: BMY) the New York based drug maker, has authorized the repurchase of $3 billion of its common stock. The decisioin reflects a cash-healthy balance sheet.

Also, at Bristol-Myers' annual meeting yesterday, two dissident shareholder proposals were soundly defeated.

Also Tuesday, stockholders at Bristol-Myers' annual meeting overwhelmingly rejected a couple of shareholder proposals. A total of 90 percent voted against a proposal that would require the company to identify, in any future proxy statements, every executive whose compensation exceeds $500,000 a year. A total of 75 percent voted against a proposal that would require Bristol-Myers to increase its public reporting on its use of animals in research and product testing, as well as on its efforts and future goals toward eliminating use of research animals.

There wasn't much market movement on any of this news, presumably because the rest of the market was taking such a beating yesterday that even a slight rise (which BMY did manage) constitutes an accomplishment.

BMY, or its precursor firms, have an impressive history, dating back to 1858, when Edward Robinson Squibb (1819-1900) started his own pharmaceutical laboratory in Brooklyn, New York. During the US civil war, Squibb invented the pannier -- a compact wooden chest that battlefield medics could use for easily carrying around the medicines used to treat casulaties.

Separately, William Bristol and John Myers formed a company in Clinton, New York in 1887.

Those two companies merged in 1989.

In 2002, BMY was involved in an accounting scandal. They were apparently "channel stuffing" and had to restate their results three years back. They agreed to pay $150 million to settle the matter, while neither admitting nor denying guilt.

Onward!

From Overstock's Former Auditor

Quote Nietzsche on us, will they??? We'll show them who's the Ubermench!

As you'll remember, and we chronicled here, on November 16, Overstock filed with the Securities and Exchange Commission an "unreviewed" Form 10-Q for its results in the quarter that ended September 30. It claimed that it had had to dismiss its auditor, Grant Thornton, because of a sudden change of heart on the part of Grant Thornton as to how a certain matter should be treated.

Specifically, it seems that the key to the dispute was the account of a particular "fulfillment partner." Often, when you order a product through Overstock's website, you are not buying it from Overstock, but from a third party, a business looking to unload its own inventory, and using Overstock as the cyberspace go-between for this purpose. Overstock has said that it accidentally overpaid one of these partners approximately $700,000 in 2008, and the partner informed it of this in February of this year. So ... doesn't that mean that the partner is acknowledging a debt, and that this debt is an asset (an account payable) that should be reflected as such on Overstock's books?

If so, then since the overpayment occurred in 2008, the account payable was an asset as of December 31, 2008. Overstock decided not to treat it as such, but to treat the later payment of $785,000 from that partner (principal and interest?) as part of its acknowledgement of the receipt of one-time non-recurring income of $1.9 million. That involved lumping the $785,000 in with certain other matters we won't trifle with here.

According to paragraph 7 of this press release, which is worth quoting in full because it has now become the crux of the controversy: As our auditors, Grant Thornton reviewed our financial statements in Q1 and Q2 2009 before we filed Form 10-Q's for those quarters. Throughout 2009, our Audit Committee has repeatedly asked Grant Thornton if there was any accounting that it would do differently, and repeatedly received the answer, "No." In fact, as recently as late-October 2009, Grant Thornton confirmed to us that it supported our accounting method for recognizing the $785,000.

Then, somehow, in November Grant Thornton changed its collective mind and decided that the account at issue should have been recorded as an asset in 2008 after all. Grant Thornton then reportedly gave Overstock an ultimatum: restate your 2008 results accordingly or we won't sign off on your third quarter filing. That's why Overstock fired them and, insteads of simply letting the clock continue to run while it searched for a new auditor -- filed the now notorious unreviewed 10Q. Of course, that clock is still running anyway, because they are out of compliance until they come up with an audited one. This filing remains bizaare.

But the new twist to the tale is that on November 20, (Friday, around the time Overstock was revealing that Nasdaq might de-list them), Grant Thornton LLP sent a letter to the Securities and Exchange Commission giving its own account of the story behind Overstock's recent 8K.

The short summary would be: "They are lying about why we left, and we left because they were lying before that." They say that (contrary to paragraph 7 as quoted above) they were not "repeatedly asked" throughout 2009 whether the treatment of this money was proper, and they never signed off on it.

"We disagree with the Company’s statement in paragraph 7 'that upon further consultation and review within the firm, Grant Thornton revised its earlier position' regarding the previously filed 2009 interim financial statements. This statement is not accurate. The Company brought the overpayment to a fulfillment partner to Grant Thornton’s attention in October. After additional discussions with the Company, the predecessor auditor and receipt of additional documentation from the Company we determined that the Company’s position as to the accounting treatment for the overpayment to a fulfillment partner was in error."

Sam Antar makes the case, not for the first time, that what is going on here is the maintenance of a cookie-jar reserve. Antar knows fraud, having committed more than his share of it. On his account, he's now trying to stay out of hell. Theology aside, I think the case he makes is worthy of the the SEC's full attention.

The whole affair continues to have the odor of Refco's hide-the-loan scheme, which unwound four years and one month ago. It looks so far like a low-rent variant of that, but it does not look good.

Mark-to-market accounting IV

IMHO, the move toward mark-to-market accounting, a gradual process through much of the 1990s and into this century, was a good idea, driven by business realities and, in its final stages, by a sensible reaction to the ludicrous bookkeeping of the late Enron Corp.

If a management's valuation model relates to reality it ought to be possible to get quotes backing that up. If it is not possible, then it is very likely management is either trying to pull something at the expense of somebody or has deluded itself, and neither possibility sounds like a sound basis for accounting rules.

"Oh, but some assets can't be sold right away except at fire sale prices!"

Market-based valuation doesn't require immediate sale. It is my understanding that conversations between corporate folk (CF) and auditors looking for GAAP compliance often go something like this.

CF: We can't mark these assets to market.

A: Why not?

CF: Nobody's buying them. So there's no market except a fire sale one.

A. How long do you think it might take you to get a non-fire sale price?

CF: Maybe six months.

A: So how much do you think you might be getting if you had started asking around for quotes six months ago?

That dialog comes (adapted by yours truly) from Einhorn's recent book.

With this, I leave the issue of mark-to-market accounting, and I'll try to get back to the chronicling of proxy fights next week.

Mark-to-market accounting III

Continuing.

On April 9 the FASB issued its final staff positions "to improve guidance and disclosures on fair value measurements and impairments," i.e. the modifications to mark-to-market.

You can see the relevant press release here.

Effects were felt immediately. Indeed, the changes were beginning to have an impact before they were finalized. I was at the Manhattan office of Kaye Scholer on April 2, the day the prelimary draft was under discussion by the FASB.

Kaye Scholer, a law firm prominent in the alt-invest world, was hosting a seminar on
“Using Private Equity and Hedge Fund Structures and Strategies to Invest in Distressed Assets.”

The consensus at the seminar was that the government, by pressuring the FASB in this direction, had cut off its nose to spite its face. For the same government was trying -- still is trying -- the get private party participation in what it calls the PPIP (public-private investment program), in which a government-organized consortium is supposed to buy 'toxic assets' from banks in order to hold them until their toxicity wears off ans re-sell them then at a profit.

In the meantime (so runs the theory) the sale of these assets by the banks will improve the balance sheets of said banks, making them more willing to make loans, and getting the wheels of commerce rolling again.

But for PPIP to work, mark-to-market accounting should still be in force. The significance of M2M is precisely that it gives banks an incentive to sell assets they aren't prepared to hold, and let somebody else, somebody more daring and speculative, perhaps a hedge fund, (or perhaps PPIP, a nineteenth century Brit lit figure in the form of a 21st century acronym) hold them instead.

The FASB decision, and other ongoing efforts by elected officials and regulators to relax mark-to-market accounting rules, would reduce banks’ incentives to sell distressed assets at prices that would make them attractive to private investor participants in the PPIP, and would thus undermining the viability of the program.

We haven't heard much from PPIP since. He's expecting a fortune from Miss Haversham but she no longer has any incentive to bestow it. (Okay, I've got the plot a bit wrong there, but I'm working with the 21st century template as best I can.)

Final thoughts on mark-to-market tomorrow.

Mark-to-market accounting II

On Thursday, April 2, the FASB met to discuss a new staff position, FSP, addressing the issue and in part modifying the system, addressing objections to M2M.

The FSP outlined how a reporting entity could determine whether a market is inactive and whether a transaction is not distressed in the sense pertinent to the application of SFAS 157. In terms of Angel’s metaphor, this is an effort to exorcise the ghost of Arthur Anderson from future auditor/reporting-entity interactions.

It established a two-step process. The first step involves the consideration of seven factors that would indicate the inactivity of a market. These factors are:
• Few recent transactions (based on volume and level of activity in the market)
• Price quotations are not based on current information
• Price quotations vary substantially either over time or among market makers (for example, some brokered markets)
• Indexes that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values
• Abnormal (or significant increases in) liquidity risk premiums or implied yields for quoted prices when compared with reasonable estimates (using realistic assumptions) of credit and other nonperformance risk for the asset class
• Abnormally wide bid-ask spread or significant increases in the bid-ask spread
• Little information is released publicly (for example, a principal-to-principal market).

The proposed FSP said that the entity shall consider the significance and relevance of each factor, yet it cautions that the list is not all-inclusive; “other factors may also indicate that a market is not active.”

If the entity concludes after step 1 that the market is not active, it has created a rebuttable presumption that a quoted price is associated with a distressed transaction. Yet it must as step 2 consider evidence that would rebut that presumption. This would be evidence that (a) there was sufficient time before the measurement date to allow for usual and customary marketing activities for the asset and (b) there were multiple bidders for the asset. If both of those factors are present, then the presumption of distress is defeated.

In the absence of one or the other of those defeating factors, the presumption of distress prevails. “When that is the case, the reporting entity must use a valuation technique other than one that uses the quoted prices without significant adjustment.

The board told its staff, "you're doing good work, but you need to go back to the drawing board and modify this a bit." That's actually my paraphrase.

Specifically, the board said the staff should “eliminate the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise.” The final FSP should also require an entity to disclose a change in valuation technique, and the related inputs, resulting from the application of this FSP and to quantity the effects of that change if practicable.

Mark-to-market accounting I

SFAS 157, issued by the FASB in 2006, became effective for financial assets and liabilities issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. It defined fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition applies to assets that are held for trading – not to assets held for investment or to maturity.
From this definition of fair value follows a three-level hierarchy of valuation based upon the type of inputs available:
• Level One inputs include directly observable market data, such as quoted prices in an active and unimpaired market;
• Level Two is applied when a market is impaired (such as the market for bonds at mid maturity), and value is derived indirectly from the prices of Level 1 assets;
• Level Three is applied when the market is inactive (such as the market for mortgage-backed securities in recent months) and value can be derived from management projections and modeling.
For a more complete account, see “Mark-to-Market Accounting in the Absence of Marks,” The Hedge Fund Law Report, Vol. 2, No. 1 (January 8, 2009).
Many institutions have complained that this system, combined with the incentives of auditors, is far too niggardly in allowing managements to move down the hierarchy from one to two, and from two to three.

They found academic support too, for instance from James Angel, Associate Professor of Finance, McDonough School of Business, Georgetown University.

I spoke to Mr. Angel not long ago, and he asked me to consider a hypothetical asset that a bank or hedge fund has purchased for a dollar.

“The management believes in its heart of hearts that its present value is $0.75. But nobody is buying that sort of asset right now, except for a bottom-fisher who offers them a nickel. Under mark-to-market strictly applied, it is worth a nickel.”

But, Angel continued, the fact that management chooses to hold on to it is evidence that it is in fact worth more than a nickel. “Its value is somewhere between 5 and 75 cents. I believe in a mark-to-management approach that would explicitly take account of management’s own view of asset value.”

More tomorrow.

Overstock and Gradient: Friends at Last

Overstock.com Inc., the discount retailer based in Salt Lake City, Utah, has announced the settlement of its lawsuit against Gradient Analytics, of Scottsdale Arizona.

Fans may recall that Gradient is the independent stock analyst formerly known as Camelback Research Alliance Inc. Overstock's complaint, brought in a state court in California, was that in 2005, Camelback conspired with hedge fund Rocker Partners to issue falsely negative reports about Overstock in order to benefit Rocker's short positions.

The settlement comes after an unsuccessful effort on Gradient's part to persuade California's courts to set aside the complaint on first amendment and/or SLAPP grounds. [SLAPP is an acronym for "strategic lawsuits against public participation," and a California law aimed at discouraging the practice of stifling public debate by such means.]

According to the statute: "A cause of action against a person arising from any act of that person in furtherance of the person's right of petition or free speech under the United States or California Constitution in connection with a public issue shall be subject to a special motion to strike, unless the court determines that the plaintiff has established that there is a probability that the plaintiff will prevail on the claim."

The word "probability" in that statute appears to mean something different for this court than it means to, say, a casino manager. The court said it isn't making a decision about which side has the better hand, but that for purposes of deciding the motion, it accepts as true all evidence favorable to the plaintiff.

Both the appellate court and the state supreme court have said that Overstock's lawsuit isn't a SLAPP, Gradient responded by filing a cross-complaint this spring, and the parties had been preparing to try the matter on the merits, with a trial date set for this coming April.

Now there's been a sudden outbreak of amity. The terms of the settlement are confidential, though Gradient put out a statement Monday, Christopher Columbus notwithstanding, saying that Overstock's accounting policies "did in fact conform with generally accepted accounting principles (GAAP) and regrets any prior statements to the contrary." Rocker Partners [or, strictly, its progeny, Copper River], remains a party.

The chairman and CEO of Overstock, Patrick Byrne, said in his company's statement: "I wish Gradient Analytics the best in their future endeavors. Overstock.com will now focus on the remaining defendants, Copper River, David Rocker, and Mark Cohodes."

Sports fans can take cheer in that last bit. There will still be a trial. The focus thereof has narrowed a bit.

More on IRF, accounting troubles

It was almost a year and a half ago -- April 2007 -- that IRF announced it was investigating accounting irregularities at one of its foreign subsidiaries. It didn't say which one, though the Japan subsidiary seems the best guess.

And the irregularity may have been a form of old-fashioned channel stuffing.

At any rate, this announcement didn't have any very dramatic immediate effect on the stock price.

But what did have an impact a few weeks later (on July 1) was the news that IRF had fired its chief financial officer, Michael P. McGee. The announcement was quite tersely worded. There was none of the common face-saving stuff. The world wasn't told that Mr. McGee had decided to "pursue other opportunities," or to spend more time with his family.

It said he had been "terminated," full stop. Then it praised his replacement, Linda Pahl, for her qualifications.

Deep into that announcement, the company reminded its investors that "an internal investigation of accounting irregularities ... continues." It drew no explciit connection between those irregularities and Mr. McGee.

Mr. Market can add though, and gets to "four" quickly enough when companies lay out the 2 plus the other 2. IRF's stock price entered the month of July 2007 at $37.50. It fell nearly to $30 before that month was out. Though it soon made a partial recovery, this was the start of a continuing slide. A year after Mr. McGee's sudden departure, IRF was selling for $17.50 a sure.

It has come off of those lows since, and largely as a result of, Vishay's interest in an acquisition.

As my readers may rightly infer from the tentative quality of these last two posts, I'm still feeling my way into this company, its history, and the proxy fight. I'll seek to lessen my own ignorance in the weeks to come.

Coca-Cola settlement

Eight years ago, a group of investors sued Coca-Cola, alleging that it had been forcing some of its bottlers to buy millions of dollars of excess beverage concentrate.

Why would it do that?

This allegation involves a faux-accounting practice known as "channel stuffing." Wherever there is a "channel" between the seller of a product and the ultimate buyer, there is a temptation on the part of the seller to push more product into that channel than there is any good reason to believe the ultimate buyers will accept. The whole of the amount pushed into the chanel is then credited as sold on the books, listed as part of the asset known as "accounts receivable."

Why would a seller do that? Because dressing up the accounts receivable in this way makes the books look good, making the company seem more valuable to credulous investors, helping thereby to boost the value of the stock.

There are a range of reasons why a company wants to see higher prices of its stock, but I'll assume here that explanation is unnecessary.

The key point here is that channel stuffing is a self-defeating strategy. The retailers can't sell all the product that has been sent them and generally return it to the wholesaler/manucaturer, who eventually has to readjust his accounts receivable, bursting whatever stock-price bubble the tactic might have created. It is tempting chiefly to managements who aren't looking that far ahead, and accordingly the (alleged) prevalence of the practice is often cited as evidence of the obsession of contemporary corporate managers with quarter-by-quarter numbers, with meeting their projects for THIS quarter and damned be the consequences.

Anyway, the institutional investor, Carpenters Health & Welfare, was the lead plaintiff in the lawsuit against Coca-Cola filed in October 2000. The company has made no admission, either pursuant to this settlement or pursuant to the settlement of a civil enforcement action brought by the SEC, settled three years ago.

Frankly, I don't think that short sightedness is the besetting sin of contemporary managements. They do have sins, but that one wouldn't be high on my list thereof. Accordingly, I suspect that the practice of channel stuffing isn't all that prevalent. That's probably why this is the first time I've mentioned the practice, or even allegations thereof, in this blog.

Still, I suspect I'll have reason to mention them -- such allegations -- again.

CSX

The hedge fund TCI contends that the railroad company CSX (which I backgrounded for you in the previous entry of this blog) should: separate the roles of chairman of the board and chief executive; refresh the Board with new independent directors; allow shareholders to call special shareholder meetings; align management compensation with shareholder interests; justify its capital spending plan to shareholders; and provide to shareholders a plan to improve operations.

Much of the heat of this still-developing proxy fight was generated in single remark in the context of a teleconference last October (the 17th) called to discussed third-quarter earnings with the stock analysts.

One of the analysts on the line, Christian Wetherbee of Merrill Lynch, noted that CSX was measuring its return-on-investment figures against book value. He asked:
"Where do you think you stand on a replacement cost basis? I'm sure you guys have done the analysis. I'm kind of curious. Is it half that level? Is it, you know, somewhere in between? higher or lower?"

Book value: how much the RR paid for its locomotives and other assets, minus depreciation for their age.

Replacement value: how much it would have to pay for equivalent assets today.

Michael Ward, the chairman and CEO of CSX, replied: "Chris, what industry looks at their ROIC on a replacement cost basis? I don't know of any industry that does that."

TCI considers that remark fatuous: just short of a declaration that Mr. Ward is running a non-profit. They've got a point. It seems intuitively obvious that replacement cost is the more sensible market-driven measure, that book value allows more scope for slushy numbers. And surely somebody at CSX is keeping track of replacement value, even if that somebody isn't Mr. Wald!

Stock price? From the summer of last year until the start of this month, CSX stock was zig-zagging about in a range between $40 and $46. In recent weeks it has broken out of that price on the upside, going above $50. I won't try to give reasons for that move here.

One of the contentions of TCI is the classic corporate goo-goo point that the roles of CEO and chairman of the board ought to be separated, that the coach and the quarerback ought to be different folk. What's behind that contention in this case is chiefly that Mr. Ward is both of those things, and TCI doesn't trust him to do either job, but would rather have him stay on in just one of them than in both.